Citi: Here’s why the Fed may be pressured to raise rates early

Two of the ways the Federal Reserve can project its key policy rate, widely used as a benchmark for lending, don’t quite match, and that may result in pressure on the Federal Reserve to raise rates earlier than expected, say economists at Citi.

When the central bank announced last month that it would begin scaling back the pace is $85 billion in monthly bond-buying stimulus, it soothed markets by promising that the fed funds rate would remain near zero until the unemployment rate falls well below 6.5%. Keeping markets in check means a belief that the Fed will abide by its promise.

But Citi’s Benjamin Mandel and Robert Sockin posit one source of tension. The Fed’s policy committee at the end of each meeting releases its summary of economic projections as well as members’ expectations for the fed funds rate, and one suggests a rate hike earlier than the other:

There’s “a large and enduring gap between the FOMC’s forecasted path of the fed funds rate and the rate implied by the FOMC’s own forecasts of economic conditions. The fed funds rate in the FOMC’s Summary of Economic Projections (SEP) lifts off from zero in 2015 and then rises gradually. In stark contrast, SEP forecasts of inflation and unemployment suggest lift off in mid-2014 and a subsequent path that is 150-200 basis points higher than the FOMC rate forecast.”

For reference, here’s a Citi chart averaging the current projections of Fed officials on unemployment and a measure of inflation:

Citi

So, what does it mean if the Fed’s two outlooks are in disagreement? Mandel and Sockin suggest it could lead to internal pressure within the Fed to hike rates early:

“This discrepancy is poised to create significant tensions and challenges for the FOMC in the year ahead. One manifestation is likely to be mounting pressure to renege on its promise to keep rates ‘lower for longer,’ the central implication of the Committee’s forward guidance. In this case, ‘lower for longer’ means roughly a year between the time when economic conditions would otherwise warrant raising rates and the FOMC’s current plan for rate hikes, and a gaping 200 basis point difference by end-2016.”

Investors believe rate hikes will occur in the first half of 2015. CME Group’s FedWatch tool projects a 54% chance of a rate hike at the April 2015 meeting
/quotes/zigman/9578325/realtimeFFJ5, based on fed funds futures contracts that bet on the future path of the policy rate.